FX Volatility Smile Construction

C Ce en nt tr re e f fo or r P Pr ra ac ct ti ic ca al l Q Qu ua an nt ti it ta at ti iv ve e F Fi in na an nc ce e
CPQF Working Paper Series

No. 20

FX Volatility Smile Construction

Dimitri Reiswich and Uwe Wystup
Authors: Dimitri Reiswich Uwe Wystup
PhD Student CPQF Professor of Quantitative Finance
Frankfurt School of Finance & Management Frankfurt School of Finance & Management
Frankfurt/Main Frankfurt/Main
d.reiswich@frankfurt-school.de u.wystup@frankfurt-school.de

April 2010
Publisher: Frankfurt School of Finance & Management
Phone: +49 (0) 69 154 008-0 Fax: +49 (0) 69 154 008-728
Sonnemannstr. 9-11 D-60314 Frankfurt/M. Germany
FX Volatility Smile Construction
Dimitri Reiswich, Uwe Wystup
Version 1: September, 8th 2009
Version 2: March, 20th 2010
Abstract The foreign exchange options market is one of the largest and most liquid
OTC derivative markets in the world. Surprisingly, very little is known in the aca-
demic literature about the construction of the most important object in this market:
The implied volatility smile. The smile construction procedure and the volatility
quoting mechanisms are FX specic and differ signicantly from other markets. We
give a detailed overview of these quoting mechanisms and introduce the resulting
smile construction problem. Furthermore, we provide a new formula which can be
used for an efcient and robust FX smile construction.
Keywords: FX Quotations, FX Smile Construction, Risk Reversal, Buttery, Stran-
gle, Delta Conventions, Malz Formula
Dimitri Reiswich
Frankfurt School of Finance & Management, Centre for Practical Quantitative Finance, e-mail:
d.reiswich@frankfurt-school.de
Uwe Wystup
Frankfurt School of Finance & Management, Centre for Practical Quantitative Finance, e-mail:
uwe.wystup@mathfinance.com
1
2 Dimitri Reiswich, Uwe Wystup
1 Delta and ATMConventions in FX-Markets
1.1 Introduction
It is common market practice to summarize the information of the vanilla options
market in the volatility smile table which includes Black-Scholes implied volatili-
ties for different maturities and moneyness levels. The degree of moneyness of an
option can be represented by the strike or any linear or non-linear transformation
of the strike (forward-moneyness, log-moneyness, delta). The implied volatility as
a function of moneyness for a xed time to maturity is generally referred to as the
smile. The volatility smile is the crucial object in pricing and risk management pro-
cedures since it is used to price vanilla, as well as exotic option books. Market par-
ticipants entering the FX OTC derivative market are confronted with the fact that the
volatility smile is usually not directly observable in the market. This is in opposite
to the equity market, where strike-price or strike-volatility pairs can be observed.
In foreign exchange OTC derivative markets it is common to publish currency pair
specic risk reversal
RR
, strangle
STR
and at-the-money volatility
ATM
quotes
as given in the market sample in Table 1. These quotes can be used to construct a
Table 1: FX Market data for a maturity of 1 month, as of January, 20th 2009
EURUSD USDJPY
ATM
21.6215% 21.00%
RR
0.5% 5.3%
STR
0.7375% 0.184%
complete volatility smile from which one can extract the volatility for any strike. In
the next section we will introduce the basic FX terminology which is necessary to
understand the following sections. We will then explain the market implied infor-
mation for quotes such as those given in Table 1. Finally, we will propose an implied
volatility function which accounts for this information.
1.2 Spot, Forward and Vanilla Options
FX Spot Rate S
t
The FX spot rate S
t
=FOR-DOM represents the number of units of domestic cur-
rency needed to buy one unit of foreign currency at time t. For example, EUR-
USD= 1.3900 means that one EUR is worth 1.3900 USD. In this case, EUR is the
Empirical FX Analysis 3
foreign currency and USD is the domestic one. The EUR-USD= 1.3900 quote is
equivalent to USD-EUR 0.7194. A notional of N units of foreign currency is equal
to NS
t
units of domestic currency (see also Wystup (2006)). The term domestic
does not refer to any geographical region. The domestic currency is also referred to
as the numeraire currency (see Castagna (2010)).
FX Outright Forward Rate f (t, T)
By far the most popular and liquid hedge contract for a corporate treasurer is the
outright forward contract. This contract trades at time t at zero cost and leads to an
exchange of notionals at time T at the pre-specied outright forward rate f (t, T).
At time T, the foreign notional amount N would be exchanged against an amount
of N f (t, T) domestic currency units. The outright forward is related to the FX spot
rate via the spot-rates parity
f (t, T) = S
t
e
(r
d
r
f
)
, (1)
where
r
f
is the foreign interest rate (continuously compounded),
r
d
is the domestic interest rate (continuously compounded),
is the time to maturity, equal to T t.
FX Forward Value
At inception an outright forward contract has a value of zero. Thereafter, when mar-
kets move, the value of the forward contract is no longer zero but is worth
v
f
(t, T) = e
r
d
( f (t, T) K) = S
t
e
r
f
Ke
r
d
(2)
for a pre-specied exchange rate K. This is the forward contract value in domestic
currency units, marked to the market at time t.
FX Vanilla Options
In foreign exchange markets options are usually physically settled, i.e. the buyer of
a EUR vanilla call (USD Put) receives a EUR notional amount N and pays N K
USD, where K is the strike. The value of such a vanilla contract is computed with
the standard Black-Scholes formula
v(S
t
, K, , ) = v(S
t
, r
d
, r
f
, K, , t, T, )
= [e
r
f
S
t
N(d
+
) e
r
d
K N(d
)] (3)
= e
r
d
[ f (t, T) N(d
+
) K N(d
)],
where
d
=
ln
_
f (t,T)
K
_
1
2
K : strike of the FX option,

: Black-Scholes volatility,
= +1 for a call , =1 for a put,
N(x) : cumulative normal distribution function.
We may drop some of the variables of the function v depending on context. The
Black-Scholes formula renders a value v in domestic currency. An equivalent value
of the position in foreign currency is v/S
t
. The accounting currency (the currency
in which the option values are measured) is also called the premium currency.
The notional is the amount of currency which the holder of an option is entitled
to exchange. The value formula applies by default to one unit of foreign notional
(corresponding to one share of stock in equity markets), with a value in units of
domestic currency. An example which illustrates these terms follows. Consider a
EUR-USD call with a spot of S
0
= 1.3900, a strike of K = 1.3500 and a price of
0.1024 USD. If a notional of 1, 000, 000 EUR is specied, the holder of the option
will receive 1, 000, 000 EUR and pay 1, 350, 000 USD at maturity and the options
current price is 102, 400 USD (73, 669 EUR).
1.3 Delta Types
The delta of an option is the percentage of the foreign notional one must buy when
selling the option to hold a hedged position (equivalent to buying stock). For in-
stance, a delta of 0.35 = 35% indicates buying 35% of the foreign notional to delta-
hedge a short option. In foreign exchange markets we distinguish the cases spot
delta for a hedge in the spot market and forward delta for a hedge in the FX forward
market. Furthermore, the standard delta is a quantity in percent of foreign currency.
The actual hedge quantity must be changed if the premium is paid in foreign cur-
rency, which would be equivalent to paying for stock options in shares of stock. We
call this type of delta the premium-adjusted delta. In the previous example the value
of an option with a notional of 1, 000, 000 EUR was calculated as 73, 669 EUR.
Assuming a short position with a delta of 60% means, that buying 600, 000 EUR is
necessary to hedge. However the nal hedge quantity will be 526, 331 EUR which
is the delta quantity reduced by the received premium in EUR. Consequently, the
premium-adjusted delta would be 52.63%. The following sections will introduce the
formulas for the different delta types. A detailed introduction on at-the-money and
delta conventions which we used as an orientation can be found in Beier and Renner
(2010). Related work, which is worth reading and describes the standard conven-
tions can also be found in Beneder and Elkenbracht-Huizing (2003), Bossens et al.
(2009), Castagna (2010), Clark (forthcoming).
Unadjusted Deltas
Spot Delta
The sensitivity of the vanilla option with respect to the spot rate S
t
is given as
S
(K, , )

=
v
S
= v
S
. (4)
Standard calculus yields
S
(K, , ) = e
r
f
N(d
+
), (5)
Put-call delta parity:
S
(K, , +1)
S
(K, , 1) = e
r
f
. (6)
In equity markets, one would buy
S
units of the stock to hedge a short vanilla
option position. In FX markets, this is equivalent to buying
S
times the foreign
notional N. This is equivalent to selling of
S
N S
t
units of domestic currency.
Note that the absolute value of delta is a number between zero and a discount factor
e
r
f
< 100%. Therefore, 50% is not the center value for the delta range.
Forward Delta
An alternative to the spot hedge is a hedge with a forward contract. The number
of forward contracts one would buy in this case differs from the number of units in
a spot hedge. The forward-hedge ratio is given by
f
(K, , )

=
v
v
f
=
v
S
S
v
f
=
v
S
_
v
f
S
_
1
= N(d
+
), (7)
f
(K, , +1)
f
(K, , 1) = 100%. (8)
In the hedge, one would enter
f
N forward contracts to forward-hedge a short
vanilla option position. The forward delta is often used in FX options smile tables,
because of the fact that the delta of a call and the (absolute value of the) delta of the
corresponding put add up to 100%, i.e. a 25-delta call must have the same volatility
as a 75-delta put. This symmetry only works for forward deltas.
Premium Adjusted Deltas
Premium-Adjusted Spot Delta
The premium-adjusted spot delta takes care of the correction induced by payment
of the premium in foreign currency, which is the amount by which the delta hedge
in foreign currency has to be corrected. The delta can be represented as
S, pa
=
S
v
S
. (9)
In this hedge scenario, one would buy N(
S
v
S
t
) foreign currency units to hedge
a short vanilla position. The equivalent number of domestic currency units to sell is
N(S
t
S
v). To quantify the hedge in domestic currency we need to ip around the
quotation and compute the dual delta
v
S
in FOR
1
S
in FOR per DOM
= DOM to buy
=

v
S
S

S
1
S
=
Sv
S
v
S
2

_
1
S
S
_
1
=
Sv
S
v
S
2

_
1
S
2
_
1
= (Sv
S
v) DOM to buy = Sv
S
v DOM to sell = v
S
v
S
FOR to buy,
which conrms the denition of the premium-adjusted delta in Equation (9). We
nd
S, pa
(K, , ) = e
r
f
K
f
N(d
), (10)
S, pa
(K, , +1)
S, pa
(K, , 1) = e
r
f
K
f
. (11)
Note that
e
r
f
K
f
N(d
) = FOR to buy per 1 FOR

e
r
d
KN(d
) = DOM to sell per 1 FOR

e
r
d
KN(d
) = DOM to buy per 1 FOR

e
r
d
N(d
) = DOM to buy per 1 DOM

= v
K
= the dual delta,
which is the strike-coefcient in the Black-Scholes Formula (3). It is now appar-
ent that this can also be interpreted as a delta, the spot delta in reverse quotation
DOM-FOR. For the premium-adjusted delta the relationship strike versus delta is
not injective: for a given delta there might exist more than one corresponding strike.
This is shown in Figure (1).
Premium-Adjusted Forward Delta
50 100 150 200
K
0.2
0.4
0.6
0.8
1.0
vK
S
Spot p.a.
Spot 50 100 150 200
K
1.5
1.0
0.5
Spot p.a.
Spot
Fig. 1: Premium-adjusted and standard call (left chart) and put (right chart) spot delta, S
t
= 100, = 1.0, r
d
= 0.03,
r
f
= 0.0, = 0.2.
As in the case of a spot delta, a premium payment in foreign currency leads to
an adjustment of the forward delta. The resulting hedge quantity is given by
f , pa
(K, , ) =
K
f
N(d
), (12)
f , pa
(K, , +1)
f , pa
(K, , 1) =
K
f
. (13)
Note again that the premium-adjusted forward delta of a call is not a monotone
function of the strike.
Delta Conventions for Selected Currency Pairs
This section is based on Ian Clarks summary of current FX market conventions (see
Clark (forthcoming)). The question which of the deltas is used in practice cannot
be answered systematically. Both, spot and forward deltas are used, depending on
which product is used to hedge. Generally, forward hedges are popular to capture
rates risk besides the spot risk. So naturally, forward hedges come up for delta-one-
similar products or for long-term options. In practice, the immediate hedge executed
is generally the spot-hedge, because it has to be done instantaneously with the option
trade. At a later time the trader can change the spot hedge to a forward hedge using
a zero-cost FX swap.
Forward delta conventions are normally used to specify implied volatilities be-
cause of the symmetry of put and call deltas adding up to 100%. Using forward
deltas as a quotation standard often depends on the time to expiry T and the pres-
ence of an emerging market currency in the currency pair. If the currency pair does
contain an emerging market currency, forward deltas are the market default. If the
currency pair contains only currencies from the OECD economies (USD, EUR, JPY,
GBP, AUD, NZD, CAD, CHF, NOK, SEK, DKK), and does not include ISK, TRY,
MXN, CZK, KRW, HUF, PLN, ZAR or SGD, then spot deltas are used out to and
including 1Y. For all longer dated tenors forward deltas are used. An example: the
NZD-JPY uses spot deltas for maturities below 1 year and forward deltas for maturi-
ties above 1 year. However, for the CZK-JPY currency pair forward deltas are used
in the volatility smile quotation(see Clark (forthcoming)). The premium-adjusted
delta as a default is used for options in currency pairs whose premium currency is
FOR. We provide examples in Table 2. The market standard is to take the more
Table 2: Selected currency pairs and their default premium currency determining the delta type. Source: Clark (forth-
coming)
Currency Pair Premium Currency Delta Convention
EUR-USD USD regular
USD-JPY USD premium-adjusted
EUR-JPY EUR premium-adjusted
USD-CHF USD premium-adjusted
EUR-CHF EUR premium-adjusted
GBP-USD USD regular
EUR-GBP EUR premium-adjusted
AUD-USD USD regular
AUD-JPY AUD premium-adjusted
USD-CAD USD premium-adjusted
USD-BRL USD premium-adjusted
USD-MXN USD premium-adjusted
commonly traded currency as the premium currency. However, this does not apply
to the JPY. Virtually all currency pairs involving the USD will have the USD as the
premium currency of the contract. Similarly, contracts on a currency pair including
the EUR - and not the USD - will be denoted in EUR. A basic premium currency
hierarchy is given as (Clark (forthcoming))
USD ~ EUR ~GBP ~AUD ~NZD ~CAD ~CHF
~ NOK,SEK,DKK
~ CZK,PLN,TRY,MXN ~JPY ~. . . (14)
Exceptions may occur, so in case of doubt it is advisable to check.
1.4 At-The-Money Denitions
Dening at-the-money (ATM) is by far not as obvious as one might think when rst
studying options. It is the attempt to specify the middle of the spot distribution in
various senses. We can think of
ATM-spot K = S
0
ATM-fwd K = f
ATM-value-neutral K such that call value = put value
ATM--neutral K such that call delta = put delta.
In addition to that, the notion of ATM involving delta will have sub-categories de-
pending on which delta convention is used. ATM-spot is often used in beginners
text books or on term sheets for retail investors, because the majority of market
participants is familiar with it. ATM-fwd takes into account that the risk-neutral ex-
pectation of the future spot is the forward price (1), which is a natural way of spec-
ifying the middle. It is very common for currency pairs with a large interest rate
differential (emerging markets) or long maturity. ATM-value-neutral is equivalent
to ATM-fwd because of the put-call parity. Choosing the strike in the ATM-delta-
neutral sense ensures that a straddle with this strike has a zero spot exposure which
accounts for the traders vega-hedging needs. This ATM convention is considered
as the default ATM notion for short-dated FX options. We summarize the various
at-the-money denitions and the relations between all relevant quantities in Table 3.
Table 3: ATM Strike values and delta values for the different delta conventions. Source: Beier and Renner (2010)
ATM -neutral Strike ATM fwd Strike ATM -neutral Delta ATM fwd Delta
Spot Delta f e
1
2
f
1
2
e
r
f
e
r
f
N(
1
2
)
Forward Delta f e
1
2
f
1
2
N(
1
2
)
Spot Delta p.a. f e
1
2
f
1
2
e
r
f
1
2
e
r
f
N(
1
2
)
Forward Delta p.a. f e
1
2
f
1
2
e
1
2
N(
1
2
)
1.5 DeltaStrike Conversion
Professional FX market participants have adapted specic quoting mechanisms
which differ signicantly from other markets. While it is common in equity mar-
kets to quote strike-volatility or strike-price pairs, this is usually not the case in
FX markets. Many customers on the buy-side receive implied volatility-delta pairs
from their market data provider. This data is usually the result of a suitable cali-
bration and transformation output. The calibration is based on data which has the
type shown in Table 1. The market participant is then confronted with the task to
transform volatility-delta to strike-price pairs respecting FX specic at-the-money
and delta denitions. This section will outline the algorithms which can be used to
that end. For a given spot delta
S
and the corresponding volatility the strike can
be retrieved with
K = f e
N
1
(e
r
f

S
)
+
1
2
. (15)
The equivalent forward delta version is
K = f e
N
1
(
f
)
+
1
2
. (16)
Conversion of a Premium-Adjusted Forward Delta to Strike
For a premium-adjusted forward delta the relationship between delta and strike
f , pa
(K, , ) =
K
f
N(d
) =
K
f
N
_
_
ln
_
f
K
_
1
2
_
_
,
can not be solved for the strike in closed form. A numerical procedure has to be
used. This is straightforward for the put delta because the put delta is monotone
in strike. This is not the case for the premium-adjusted call delta, as illustrated in
Figure (1). Here, two strikes can be obtained for a given premium-adjusted call delta
(for example for
S,pa
= 0.2). It is common to search for strikes corresponding to
deltas which are on the right hand side of the delta maximum. This is illustrated as
a shadowed area in the left chart of Figure (2).
50 100 150 200
0.1
0.2
0.3
0.4
0.5
0.6
K
50 100 150 200

0.2
0.4
0.6
0.8
1.0
K
min
K
max K
Fig. 2: Strike region for given premium-adjusted delta. S

t
= 100
Consequently, we recommend to use Brents root searcher (see Brent (2002)) to
search for K [K
min
, K
max
]. The right limit K
max
can be chosen as the strike corre-
sponding to the non premium-adjusted delta, since the premium-adjusted delta for a
strike K is always smaller than the simple delta corresponding to the same strike. For
example, if we are looking for a strike corresponding to a premium-adjusted forward
delta of 0.20, we can choose K
max
to be the strike corresponding to a simple forward
delta of 0.20. The last strike can be calculated analytically using Equation (16). It
is easy to see that the premium-adjusted delta is always below the non-premium-
adjusted one. This follows from
S
(K, , )
S, pa
(K, , ) = e
r
f
N(d
+
) e
r
f
K
f
N(d
) 0
f N(d
+
) KN(d
) 0.
Discounting the last inequality yields the Black-Scholes formula, which is always
positive. The maximum for both, the premium-adjusted spot and premium-adjusted
forward delta, is given implicitly by the equation
N(d
) = n(d
),
with n(x) being the normal density at x. One can solve this implicit equation numer-
ically for K
min
and then use Brents method to search for the strike in [K
min
, K
max
].
The resulting interval is illustrated in the right hand side of Figure (2).
Construction of Implied Volatility Smiles
The previous section introduced the FX specic delta and ATM conventions. This
knowledge is crucial to understand the volatility construction procedure in FX mar-
kets. In FX option markets it is common to use the delta to measure the degree
of moneyness. Consequently, volatilities are assigned to deltas (for any delta type),
rather than strikes. For example, it is common to quote the volatility for an option
which has a premium-adjusted delta of 0.25. These quotes are often provided by
market data vendors to their customers. However, the volatility-delta version of the
smile is translated by the vendors after using the smile construction procedure dis-
cussed below. Other vendors do not provide delta-volatility quotes. In this case, the
customers have to employ the smile construction procedure. Related sources cov-
ering this subject can be found in Bossens et al. (2009), Castagna (2010), Clark
(forthcoming).
Unlike in other markets, the FX smile is given implicitly as a set of restrictions
implied by market instruments. This is FX-specic, as other markets quote volatil-
ity versus strike directly. A consequence is that one has to employ a calibration
procedure to construct a volatility vs. delta or volatility vs. strike smile. This section
introduces the set of restrictions implied by market instruments and proposes a new
method which allows an efcient and robust calibration.
Suppose the mapping of a strike to the corresponding implied volatility
K (K)
is given. We will not specify (K) here but treat it as a general smile function for
the moment. The crucial point in the construction of the FX volatility smile is to
build (K) such that it matches the volatilities and prices implied by market quotes.
The FX market uses three volatility quotes for a given delta such as =0.25
1
:
an at-the-money volatility
ATM
,
a risk reversal volatility
25RR
,
a quoted strangle volatility
25SQ
.
A sample of market quotes for the EURUSD and USDJPY currency pairs is given
in Table 4. Before starting the smile construction it is important to analyze the exact
Table 4: Market data for a maturity of 1 month, as of January, 20th 2009
EURUSD USDJPY
S
0
1.3088 90.68
r
d
0.3525% 0.42875%
r
f
2.0113% 0.3525%
ATM
21.6215% 21.00%
25RR
0.5% 5.3%
25SQ
0.7375% 0.184%
characteristics of the quotes in Table 4. In particular, one has to identify rst
which at-the-money convention is used,
which delta type is used.
For example, Figure (3) shows two market consistent smiles based on the EURUSD
market data from Table 4, assuming that this data refers to different deltas, a sim-
ple or premium-adjusted one. It is obvious, that the smiles can have very differ-
ent shapes, in particular for out-of-the-money and in-the-money options. Misunder-
standing the delta type which the market data refers to would lead to a wrong pricing
of vanilla options. The quotes in the given market sample refer to a spot delta for
the currency pair EURUSD and a premium-adjusted spot delta for the currency pair
USDJPY. Both currency pairs use the forward delta neutral at-the-money quotation.
The next subsections explain which information these quotes contain.
At-the-Money Volatility
After identifying the at-the-money type, we can extract the at-the-money strike
K
ATM
as summarized in Table 3. For the market sample data in Table 4 the cor-
responding strikes are summarized in Table 5. Independent of the choice of (K),
1
We will take a delta of 0.25 as an example, although any choice is possible.
1.10 1.15 1.20 1.25 1.30 1.35 1.40 1.45 1.50
K
0.20
0.21
0.22
0.23
0.24
0.25
0.26
Spot p.a.
Spot
Fig. 3: Smile construction with EURUSD market data from Table 4, assuming different delta types.
Table 5: At-the-money strikes for market sample
EURUSD USDJPY
K
ATM
1.3096 90.86
it has to be ensured that the volatility for the at-the-money strike is
ATM
. Conse-
quently, the construction procedure for (K) has to guarantee that the following
Equation
(K
ATM
) =
ATM
(17)
holds. A market consistent smile function (K) for the EURUSD currency pair thus
has to yield
(1.3096) = 21.6215%
for the market data in Table 4. We will show later how to calibrate (K) to re-
trieve (K), so assume for the moment that the calibrated, market consistent smile
function (K) is given.
Risk Reversal
The risk reversal quotation
25RR
is the difference between two volatilities:
the implied volatility of a call with a delta of 0.25 and
the implied volatility of a put with a delta of 0.25.
It measures the skewness of the smile, the extra volatility which is added to the
0.25 put volatility compared to a call volatility which has the same absolute delta.
Clearly, the delta type has to be specied in advance. For example, the implied
volatility of a USD call JPY put with a premium-adjusted spot delta of 0.25 could
be considered. Given (K), it is possible to extract strike-volatility pairs
2
for a call
and a put
_
K
25C
, (K
25C
)
_ _
K
25P
, (K
25P
)
_
which yield a delta of 0.25 and 0.25 respectively:
(K
25C
, (K
25C
), 1) = 0.25
(K
25P
, (K
25P
), 1) =0.25
In the equation system above, denotes a general delta which has to be specied to
S
,
S,pa
or
f
,
f ,pa
. The market consistent smile function (K) has to match the
information implied in the risk reversal. Consequently, it has to fulll
(K
25C
) (K
25P
) =
25RR
. (18)
Examples of such 0.25 strike-volatility pairs for the market data in Table 4 and a
calibrated smile function (K) are given in Table 6.
For the currency pair EURUSD we can calculate the difference of the 0.25 call
Table 6: 0.25 strikes
EURUSD USDJPY
K
25C
1.3677 94.10
K
25P
1.2530 86.51
(K
25C
) 22.1092% 18.7693%
(K
25P
) 22.6092% 24.0693%
and put volatilities as
(1.3677) (1.2530) = 22.1092%22.6092% =0.5%
which is consistent with the risk reversal quotation in Table 4. It can also be veried
that
S
(1.3677, 22.1092%, 1) = 0.25 and
S
(1.2530, 22.6092%, 1) =0.25.
2
This can be achieved by using a standard root search algorithm.
Market Strangle
The strangle is the third restriction on the function (K). Dene the market strangle
volatility
25SM
as
25SM
=
ATM
+
25SQ
. (19)
For the market sample from Table 4 and the USDJPY case this would correspond to
25SM
= 21.00%+0.184% = 21.184%.
Given this single volatility, we can extract a call strike K
25CSM
and a put strike
K
25PSM
which - using
25SM
as the volatility - yield a delta of 0.25 and 0.25
respectively. The procedure to extract a strike given a delta and volatility has been
introduced in Section 1.5. The resulting strikes will then fulll
(K
25CSM
,
25SM
, 1) = 0.25 (20)
(K
25PSM
,
25SM
, 1) =0.25. (21)
The strikes corresponding to the market sample are summarized in Table 7. For the
USDJPY case the strike volatility combinations given in Table 7 fulll
S,pa
(94.55, 21.184%, 1) = 0.25 (22)
S,pa
(87.00, 21.184%, 1) = 0.25 (23)
where
S,pa
(K, , ) is the premium-adjusted spot delta. Given the strikes K
25CSM
,
K
25PSM
and the volatility
25SM
, one can calculate the price of an option posi-
tion of a long call with a strike of K
25CSM
and a volatility of
25SM
and a long
put with a strike of K
25PSM
and the same volatility. The resulting price v
25SM
is
v
25SM
= v(K
25CSM
,
25SM
, 1) +v(K
25PSM
,
25SM
, 1) (24)
and is the nal variable one is interested in. This is the third information implied
by the market: The sum of the call option with a strike of K
25CSM
and the put
option with a strike of K
25PSM
has to be v
25SM
. This information has to be in-
corporated by a market consistent volatility function (K) which can have different
volatilities at the strikes K
25CSM
, K
25PSM
but should guarantee that the corre-
sponding option prices at these strikes add up to v
25SM
. The delta of these options
with the smile volatilities is not restricted to yield 0.25 or 0.25. To summarize,
v
25SM
= v(K
25CSM
, (K
25CSM
), 1) +v(K
25PSM
, (K
25PSM
), 1) (25)
is the last restriction on the volatility smile. Taking again the USDJPYas an example
yields that the strangle price to be matched is
v
25SM
= v(94.55, 21.184%, 1) +v(87.00, 21.184%, 1) = 1.67072. (26)
The resulting price v
25SM
is in the domestic currency, JPY in this case. One can
then extract the volatilities from a calibrated smile (K) as in Table 7 and calcu-
late the strangle price with volatilities given by the calibrated smile function (K)
v(94.55, 18.5435%, 1) +v(87.00, 23.7778%, 1) = 1.67072. (27)
This is the same price as the one implied by the market in Equation (26).
Table 7: Market Strangle data
EURUSD USDJPY
K
25CSM
1.3685 94.55
K
25PSM
1.2535 87.00
(K
25CSM
) 22.1216% 18.5435%
(K
25PSM
) 22.5953% 23.7778%
v
25SM
0.0254782 1.67072
The introduced smile construction procedure is designed for a market that quotes
three volatilities. This is often the case for illiquid markets. It can also be used for
markets where more than three volatilities are quoted on an irregular basis, such that
these illiquid quotes might not be a necessary input.
The Simplied Formula
Very often, a simplied formula is stated in the literature which allows an easy
calculation of the 0.25 delta volatilities given the market quotes. Let
25C
be the call
volatility corresponding to a delta of 0.25 and
25P
the 0.25 delta put volatility.
Let K
25C
and K
25P
denote the corresponding strikes. The simplied formula states
that
25C
=
ATM
+
1
2
25RR
+
25SQ
25P
=
ATM
1
2
25RR
+
25SQ
. (28)
This would allow a simple calculation of the 0.25 volatilities
25C
,
25P
with mar-
ket quotes as given in Table 4. Including the at-the-money volatility would result in
a smile with three anchor points which can then be interpolated in the usual way. In
this case, no calibration procedure is needed. Note, that
25C
25P
=
25RR
(29)
such that the 0.25 volatility difference automatically matches the quoted risk re-
versal volatility. The simplied formula can be reformulated to calculate
25SQ
,
given
25C
,
25P
and
ATM
quotes. This yields
25SQ
=

25C
+
25P
2

ATM
, (30)
which presents the strangle as a convexity parameter. However, the problem arises
in the matching of the market strangle as given in Equation (24), which we repeat
here for convenience
v
25SM
= v(K
25CSM
,
25SM
, 1) +v(K
25PSM
,
25SM
, 1).
Interpolating the smile from the three anchor points given by the simplied formula
and calculating the market strangle with the corresponding volatilities at K
25PSM
and K
25CSM
does not necessary lead to the matching of v
25SM
. The reason why
the formula is stated very often (see for example Malz (1997)) is that the market
strangle matching works for small risk reversal volatilities
25RR
. Assume that
25RR
is zero. The simplied Formula (28) then reduces to
25C
=
ATM
+
25SQ
,
25P
=
ATM
+
25SQ
.
This implies, that the volatility corresponding to a delta of 0.25 is the same as
the volatility corresponding to a delta of 0.25, which is the same as the mar-
ket strangle volatility
25SM
introduced in Equation (19). Assume that in case
of a vanishing risk reversal the smile is built using three anchor points given by
the simplied formula and one is asked to price a strangle with strikes K
25CSM
and K
25PSM
. Given the volatility
25C
=
ATM
+
25SQ
and a delta of 0.25
would result in K
25CSM
as the corresponding strike. Consequently, we would as-
sign
ATM
+
25SQ
to the strike K
25CSM
if we move from delta to the strike
space. Similarly, a volatility of
ATM
+
25SQ
would be assigned to K
25PSM
.
The resulting strangle from the three anchor smile would be
v(K
25CSM
,
ATM
+
25SQ
, 1) +v(K
25PSM
,
ATM
+
25SQ
, 1)
which is exactly the market strangle price v
25SM
. In this particular case, we have
K
25CSM
= K
25C
,
K
25PSM
= K
25P
.
Using the simplied smile construction procedure yields a market strangle consis-
tent smile setup in case of a zero risk reversal. The other market matching require-
ments are met by default. In any other case, the strangle price might not be matched
which leads to a non market consistent setup of the volatility smile.
The simplied formula can still be useful, even for large risk reversals, if
25SQ
is replaced by some other parameter introduced below. This parameter can be ex-
tracted after nishing the market consistent smile construction and is calculated in
a way which is similar to Equation (30). Assume that the 0.25 delta volatilities
25C
= (K
25C
) and
25P
= (K
25P
) are given by the calibrated smile function
(K). We can then calculate another strangle, called the smile strangle via
25SS
=
(K
25C
) +(K
25P
)
2

ATM
. (31)
The smile strangle measures the convexity of the calibrated smile function and is
plotted in Figure (4). It is approximately the difference between a straight line be-
tween the 25 put and call volatilities and the at-the-money volatility, evaluated
at
ATM
.
3
This is equivalent to Equation (30), but in this case we are using out-
82 84 86 88 90 92 94 96
K
0.19
0.20
0.21
0.22
0.23
0.24
R
Fig. 4: Smile strangle for random market data. Filled circles indicate K
25P
, K
25C
strikes. Rectangle indicates K
ATM
.
of-the-money volatilities obtained from the calibrated smile and not from the sim-
plied formula. Given
25SS
, the simplied Equation (28) can still be used if
the quoted strangle volatility
25SQ
is replaced by the smile strangle volatility
25SS
. Clearly,
25SS
is not known a priori but is obtained after nishing the
calibration. Thus, one obtains a correct simplied formula as
25C
=
ATM
+
1
2
25RR
+
25SS
,
25P
=
ATM
1
2
25RR
+
25SS
. (32)
A sample data example is summarized in Table 8 where we have used the calibrated
smile function (K) to calculate the smile strangles
25SS
. Given
25SS
,
ATM
and
25RR
, we can calculate the EURUSD out-of-the-money volatilities of the call
and put via the simplied Formula (32) as
3
Here,
ATM
is the at-the-money delta. The description is exact if we consider the forward delta
case with the delta-neutral at-the-money quotation. In other cases, this is an approximation.
Table 8: Smile strangle data
EURUSD USDJPY
(K
25C
) 22.1092% 18.7693%
(K
25P
) 22.6092% 24.0693%
ATM
21.6215% 21.00%
25RR
0.5% 5.3%
25SS
0.7377% 0.419%
25SQ
0.7375% 0.184%
25C
= 21.6215%
1
2
0.5%+0.7377% = 22.1092%,
25P
= 21.6215%+
1
2
0.5%+0.7377% = 22.6092%,
which is consistent with the volatilities (K
25C
) and (K
25P
) in Table 8. Note that
the market strangle volatility is very close to the smile strangle volatility in the
EURUSD case. This is due to the small risk reversal of the EURUSD smile. Cal-
culating the 25 volatilities via the original simplied Formula (28) would yield a
call volatility of 22.109% and a put volatility of 22.609% which are approximately
the 0.25 volatilities of Table 8. However, the smile strangle and quoted strangle
volatilities differ signicantly for the skewed JPYUSD smile. Using the original
Formula (28) in this case would result in 18.534% and 23.834% for the 25 call
and put volatilities. These volatilities differ from the market consistent 25 volatil-
ities given in Table 8.
Simplied Parabolic Interpolation
Various different interpolation methods can be considered as basic tools for the cali-
bration procedure. Potential candidates are the SABR model introduced by Hagan et
al. (2002), or the Vanna Volga method introduced by Castagna and Mercurio (2006).
In this work, we introduce a new method for the smile construction. In a proceeding
paper, we will compare all methods and analyze their calibration robustness empir-
ically. The method introduced below turns out to be the most robust method.
In Malz (1997), the mapping forward delta against volatility is constructed as a
polynomial of degree 2. This polynomial is constructed such that the at-the-money
and risk reversal delta volatilities are matched. Malz derives the following functional
relationship
(
f
) =
ATM
2
25RR
(
f
0.5) +16
25SQ
(
f
0.5)
2
(33)
where
f
is a call forward delta
4
. This is a parabola centered at 0.5. The use of this
functional relationship can be problematic due to the following set of problems:
the interpolation is not a well dened volatility function since it is not always
positive,
the representation is only valid for forward deltas, although the author incorrectly
uses the spot delta in his derivation (see Equation (7) and Equation (18) in Malz
[1997]),
the formula is only valid for the forward delta neutral at-the-money quotation,
the formula is only valid for risk reversal and strangle quotes associated with a
delta of 0.25,
the matching of the market strangle restriction (25) is guaranteed for small risk
reversals only.
The last point is crucial! If the risk reversal
25RR
is close to zero, the formula will
yield
ATM
+
25SQ
as the volatility for the 0.25 call and put delta. This is con-
sistent with restriction (25). However, a signicant risk reversal will lead to a failure
of the formula. We will x most of the problems by deriving a new, more general-
ized formula with a similar structure. The problem that the formula is restricted to a
specic delta and at-the-money convention can be xed easily. The matching of the
market strangle will be employed by a suitable calibration procedure. The resulting
equation will be denoted as the simplied parabolic formula.
The simplied parabolic formula is constructed in delta space. Let a general delta
function (K, , ) be given and K
ATM
be the at-the-money strike associated with
the given at-the-money volatility
ATM
. Let the risk reversal volatility quote corre-
sponding to a general delta of

> 0 be given by
RR
. For the sake of a com-
pact notation of the formula we will use
R
instead of
RR
. Furthermore, we
parametrize the smile by using a convexity parameter called smile strangle which
is denoted as
S
. This parameter has been discussed before in the simplied formula
section. The following theorem can be stated.
Theorem 1. Let
ATM
denote the call delta implied by the at-the-money strike
ATM
= (K
ATM
,
ATM
, 1).
Furthermore, we dene a variable a which is the difference of a call delta, corre-
sponding to a

put delta, and the

put delta for any delta type and is given
by
a := (K
P
, , 1) (K
P
, , 1).
Given a call delta , the parabolic mapping
(,
S
) (,
S
)
which matches
ATM
and the
RR
risk reversal quote by default is
4
A put volatility can be calculated by transforming the put to a call delta using the put call parity.
(,
S
) =
ATM
+c
1
(
ATM
) +c
2
(
ATM
)
2
(34)
with
c
1
=
a
2
(2
S
+
R
) 2a(2
S
+
R
)(

+
ATM
) +2(

R
+4
S

ATM
+
R
2
ATM
)
2(2

a)(

ATM
)(

a+
ATM
)
c
2
=
4

S
a(2
S
+
R
) +2
R
ATM
2(2

a)(

ATM
)(

a+
ATM
)
(35)
assuming that the denominator of c
1
(and thus c
2
) is not zero. A volatility for a put
delta can be calculated via the transformation of the put delta to a call delta.
Proof: See Appendix.
We will present (,
S
) as a function depending on two parameters only, although
of course more parameters are needed for the input. We consider
S
explicitly, since
this is the only parameter not observable in the market. This parameter will be the
crucial object in the calibration procedure. Setting

= 0.25,
ATM
= 0.5 and a = 1
as in the forward delta case, yields the original Malz formula if
S
=
25SQ
.
The generalized formula can handle any delta (e.g

= 0.10), any delta type and
any at-the-money convention. The formula automatically matches the at-the-money
volatility, since
(
ATM
,
S
) =
ATM
Furthermore, the risk reversal is matched since
(

C
,
S
) (a+

P
,
S
) =
RR
where

C
denotes the call delta and

P
the put delta
5
.
We have plotted the calibrated strike vs. volatility function in Figure (5) to show the
inuence of the parameters
ATM
,
R
,
S
on the simplied parabolic volatility smile
in the strike space. We will explain later how to move from the delta to the strike
space. Increasing
ATM
leads to a parallel upper shift of the smile. Increasing
25RR
yields to a more skewed curve. A risk reversal of zero implies a symmetric smile.
Increasing the strangle
S
increases the at-the-money smile convexity. Our nal goal
will be the adjustment of the smile convexity by changing
S
until condition (25)
is met. The other conditions are fullled by default, independent of the choice of
S
.
We note that the simplied parabolic formula follows the sticky-delta rule. This
implies, that the smile does not move in the delta space, if the spot changes (see
Balland (2002), Daglish et al. (2007), Derman (1999)). In the strike space, the smile
performs a move to the right in case of an increasing spot, see Figure (6) .
5
a+

P
is the call delta corresponding to a put delta of

P
. In the forward delta case a =1. If

P
=
0.25, the equivalent call delta which enters the simplied parabolic formula is a+

P
= 0.75.
1.10 1.15 1.20 1.25 1.30
K 0.00
0.05
0.10
0.15
0.20
0.25
ATM0.14
ATM0.12
ATM0.10
1.10 1.15 1.20 1.25 1.30
K 0.00
0.05
0.10
0.15
0.20
0.25
R0.04
R0.0
R0.04
1.10 1.15 1.20 1.25 1.30
K 0.00
0.05
0.10
0.15
0.20
0.25
S0.05
S0.03
S0.01
Fig. 5: Simplied Parabolic
ATM
,
R
,
S
spot delta scenarios with =
35
365
, S
0
= 1.2, r
d
= 0.03, r
f
= 0.01,

= 0.25.
Initial parameters
ATM
= 10.0%,
R
= 0.6%,
S
= 1.0%.
1.1 1.2 1.3 1.4 1.5 1.6 1.7
K
0.20
0.21
0.22
0.23
0.24
0.25
0.26
Spot1.3588
Spot1.3088
Fig. 6: Moving spot scenario for calibrated simplied parabolic formula in strike space. Based on market data in Table 3.
Market Calibration
The advantage of Formula (34) is that it matches the at-the-money and risk reversal
conditions of Equations (17) and (18) by default. The only remaining challenge is
matching the market strangle. The simplied parabolic function can be transformed
from a delta-volatility to a strike-volatility space (which will be discussed later) such
that a function
(K,
S
)
is available. Using the variable
S
as the free parameter, the calibration problem can
be reduced to a search for a variable x such that the following holds
v

SM
= v(K
CSM
, (K
CSM
, x), 1)
+ v(K
PSM
, (K
PSM
, x), 1). (36)
This leads to the following root search problem:
Problem Type: Root search.
Given parameters: v

SM
, K
CSM
, K
PSM
and market data.
Target parameter: x (set x initially to
SQ
)
Objective function:
f (x) = v(K
CSM
, (K
CSM
, x), 1) +v(K
PSM
, (K
PSM
, x), 1) v

SM
The procedure will yield a smile strangle which can be used in the simplied
parabolic formula to construct a full smile in the delta space. It is natural to ask,
how well dened the problem above is and whether a solution exists. We will not
present a rigorous analysis of this problem here, but it will be presented in follow-up
research. We will show that a solution exists in a neighborhood of
R
= 0 assuming
that a weak condition is fullled. However, the neighborhood might be very small
such that no solution for large risk-reversals might be available. The empirical tests
in the following section will show, that the non-existence of such a solution has oc-
curred in the past in very extreme market scenarios.
Performing the calibration on the currency data in Table 4 yields the parameters
summarized in Table 7 for the root search problem. The nal calibrated smile for
Table 7: Simplied Parabolic Calibration Results
EURUSD Sample USDJPY Sample
S
0.007377 0.00419
the JPYUSD case is illustrated in Figure (8).
75 80 85 90 95
K
0.18
0.20
0.22
0.24
0.26
0.28
25 RR
ATM
Fig. 8: JPYUSD smile for the market data in Exhibit 4. Filled circles indicate K
25P
, K
25C
strikes. Unlled circles indicate
market strangle strikes K
25PSM
, K
25CSM
. Rectangle indicates K
ATM
.
Retrieving a Volatility for a Given Strike
Formula (34) returns the volatility for a given delta. However, the calibration proce-
dure requires a mapping
K (K,
S
)
since it needs a volatility corresponding to the market strangle strikes. The transfor-
mation to (K,
S
) can be deduced by recalling that = (,
S
) is the volatility
corresponding to the delta . To be more precise, given that is assigned to delta
implies that = (K, , ) for some strike K. Consequently, Formula (34) can
be stated as
=
ATM
+c
1
((K, , 1)
ATM
) +c
2
((K, , 1)
ATM
)
2
. (37)
Given a strike K, it is thus possible to retrieve the corresponding volatility by
searching for a which fullls Equation (37). This can be achieved by using a
root searcher. We recommend the method introduced by Brent (2002). The question
arises, if such a volatility vs. strike function exists and how smooth it is. The answer
can be given by using the implicit function theorem. In the following discussion we
will avoid the explicit dependence of all variables on (K, (K,
S
)). For example,
we write
K
instead of

K
(x, y)[
x=K,y=(K,
S
)
With this compact notation, we can state the following.
Theorem 2. Given the volatility vs. delta mapping (34), assume that the following
holds
c
1
(K
ATM
,
ATM
) ,= 1
Then there exists a function : U W with open sets U,W IR
+
such that K
ATM

U and
ATM
W which maps the strike implicit in against the corresponding
volatility. The function is differentiable and has the following rst- and second-
order derivatives on U
K
=
K
A
1
A
(38)
K
2
=
__
K
2
+

2
K
_
A+

K
A
K
__
1
A
_
_
1
A
_
2
+
K
A
_
(

K
+

2
K
)A+

A
K
_
_
1
A
_
2
(39)
with
A := c
1
+2c
2
(
ATM
) and
A
K
= 2c
2
_
K
+

K
_
Proof. See Appendix.
Note that Equations (38) and (39) require the values (K,
S
). In fact, Equa-
tion (38) can be seen as an non-autonomous non-linear ordinary differential equation
for (K,
S
). However, given (K,
S
) as a root of Equation (37), we can analyt-
ically calculate both derivatives. Differentiability is very important for calibration
procedures of the well known local volatility models (see Dupire (1994), Derman
and Kani (1994), Lee (2001)), which need a smooth volatility vs. strike function. To
be more precise, given the local volatility SDE
dS
t
= (r
d
r
f
)S
t
dt +(S
t
, t)dW
t
the function (K, t) can be stated in terms of the implied volatility (see Andersen
and Brotherton-Ratcliffe (1998), Dempster and Richards (2000)) as
2
(K, T) =
2
T
+

Tt
+2K(r
d
r
f
)
K
K
2
_
K
2
d
+
T t(
K
)
2
+
1
_
1
K
Tt
+d
+

K
_
2
_
.
The derivatives with respect to the strike can be very problematic if calculated nu-
merically from an interpolation function. In our case, the derivatives can be stated
explicitly, similar to (Hakala and Wystup, 2002, page 254) for the kernel interpo-
lation case. In addition, the formulas are very useful to test for arbitrage, where
restrictions on the slope and convexity of (K) are imposed (see for example Lee
(2005)).
We summarize explicit formulas for all derivatives occurring in Equations (38) and
(39) in Tables 10 and 11 in the Appendix. They can be used for derivations of ana-
lytical formulas for the strike derivatives for all delta types.
Extreme Strike Behavior
Lee (2004) published a very general result about the extreme strike behavior of any
implied volatility function. Work in this area has been continued by Benaim, Friz
and Lee in Benaim et al. (2009), Benaim and Friz (2009). The basic idea of Lee is
the following. Let
x := ln
_
K
f
_
be the log-moneyness and I
2
(x) the implied variance for a given moneyness x. In-
dependent of the underlying model for the asset S there exists a
R
[0, 2] such
that
R
:= limsup
x
I
2
(x)
[x[/T
.
A very important result is that the number
R
is directly related to the highest nite
moment of the underlying S at time T such that
R
can be stated more explicitly
depending on the model. Dene
p := supp : E(S
1+p
T
) <.
then we have
R
= 24(
_
p
2
+ p p),
where the right hand expression is to be read as zero in the case p = . A similar
expression can be obtained for x . Consequently, the modeling of the implied
volatility function in the delta space can not be arbitrarily, since Lees extreme strike
behavior has to be fullled. In the Appendix, we prove the following extreme strike
behavior for the simplied parabolic formula:
lim
x
(
S
(x),
S
) =
ATM
c
1
ATM
+c
2
2
ATM
, (40)
which is a constant. Similarly,
lim
x
(
S
(x),
S
) =
ATM
+c
1
(e
r
f
ATM
) +c
2
(e
r
f
ATM
)
2
, (41)
which is again a constant. Equivalent results can be derived for the forward delta and
the premium-adjusted versions. Consequently, the simplied formula implies a con-
stant extrapolation, which is consistent with Lees moment formula. The constant
extrapolation implies that
lim
x
I(x)
_
[x[/T
= 0 = lim
x
I(x)
_
[x[/T
.
This is only consistent, if
supp : E(S
p+1
T
) < =,
e.g. all moments of the underlying at time T are nite. Although the simplied
parabolic formula has been derived with a rather heuristic argumentation, it is only
consistent if the underlying that generates such a volatility smile has nite moments
of all orders.
Potential Problems
Potential numerical issues may arise due to the following:
1. Formula (34) is not restricted to yield positive values.
2. A root for Equation (37) might not exist. We do not know how large U,W are
and whether a volatility can be found for any strike K.
3. The denominator in equation system (35) can be zero.
4. A root for Equation (36) might not exist.
The question arises, how often these problems occur in the daily market calibration.
We have analyzed the occurrence of the problems above based on market data pub-
lished on Bloomberg, where
ATM
,
10RR
,
25RR
and
10SQ
,
25SQ
volatil-
ities are quoted. We have considered the currencies EUR, GBP, JPY, CHF, CAD
and AUD, which account for 88% of the worldwide traded OTC derivative notion-
als
6
. The data is summarized in Figure (9). The volatilities are quoted for maturities
of 1, 3, 6, 9 and 12 months. The delta types for all maturities below 9 months are
spot deltas for the currency pairs EURUSD, GBPUSD, AUDUSD and premium-
adjusted spot deltas for the currency pairs USDJPY, USDCHF, USDCAD. For the
12 month maturity, the rst currency group uses forward deltas, while the second
one uses premium-adjusted forward deltas. All currencies use the forward delta neu-
tral straddle as the at-the-money convention. We have performed a daily calibration
Table 9: FX Data Summary
EURUSD GBPUSD USDJPY USDCHF USDCAD AUDUSD
Begin Date 03.10.2003 03.10.2003 03.10.2003 05.01.2006 03.10.2003 03.10.2003
End Date 20.01.2009 20.01.2009 20.01.2009 20.01.2009 20.01.2009 20.01.2009
Data Sets 5834 5780 6126 3849 5775 5961
to market data for all maturities and currencies. The calibrations were performed to
the 0.25 and 0.10 quotes separately. Then we have tested for problems occurring
within a 0.10 range. A check for a zero denominator in equation system (35) has
been performed. Finally, we checked the existence of a root for the implied problem
(37). In none of the more than 30, 000 calibrations did we observe any of the rst
three problems. We thus conclude, that the method is very robust in the daily cali-
bration.
However, the calibration failed 6 times (in more than 30, 000 calibrations) in the root
searching procedure for Equation (36). This happened for the 0.10 case for the ex-
tremely skewed currency pair JPYUSD, where risk reversals of 19% and more were
observed in the extreme market scenarios following the nancial crisis. The calibra-
tion procedure is more robust than other methods which have shown more than 300
failures in some cases. Also, it is not obvious whether any smile function can match
the market quotes in these extreme scenarios. These issues will be covered in future
research.
6
Based on data as of December 2008, published by the Bank for International Settlements on
www.bis.org/publ/qtrpdf/r qa0906.pdf
2 Conclusion
We have introduced various delta and at-the-money quotations commonly used in
FX option markets. The delta types are FX-specic, since the option can be traded in
both currencies. The various at-the-money quotations have been designed to account
for large interest rate differentials or to enforce an efcient trading of positions with
a pure vega exposure. We have then introduced the liquid market instruments that
parametrize the market and have shown which information they imply. Finally, we
derived a new formula that accounts for FX specic market information and can be
used to employ an efcient market calibration.
Follow-up research will compare the robustness and potential problems of differ-
ent smile calibration procedures by using empirical data. Also, potential calibration
problems in extreme market scenarios will be analyzed.
Acknowledgments
We would like to thank Travis Fisher, Boris Borowski, Andreas Weber, J urgen
Hakala and Ian Clark for their helpful comments.
3 Appendix
To reduce the notation, we will drop the dependence of (,
S
) on
S
in the fol-
lowing proofs and write () instead.
Proof (Simplied Parabolic Formula). We will construct a parabola in the call delta
space such that the following restrictions are met
(
ATM
) =
ATM
,
(

) =
ATM
+
1
2
R
+
S
,
(a

) =
ATM
1
2
R
+
S
. (42)
For example, in the forward delta case we would have a = 1. Given

= 0.25, the
call delta corresponding to a put delta of 0.25 would be 1 0.25 = 0.75. The
equation system is set up such that
S
=
(

) +(a

)
2

ATM
.
One can see that
S
measures the smile convexity, as it is the difference of the
average of the out-of-the-money and in-the-money volatilities compared to the at-
the-money volatility. The restriction set (42) ensures that
(

) (a

) =
R
(43)
is fullled by default. Given the parabolic setup
() =
ATM
+c
1
(
ATM
) +c
2
(
ATM
)
2
,
one can solve for c
1
, c
2
such that Equation system (42) is fullled. This is a well
dened problem: a system of two linear equations in two unknowns. .
Proof (Existence of a Volatility vs Strike Function). The simplied parabolic func-
tion has the following form
(,
S
) =
ATM
+c
1
(
ATM
) +c
2
(
ATM
)
2
. (44)
First of all, note that (K, ) is continuously differentiable with respect to both
variables for all delta types. Dene F : IR
+
IR
+
IR to be
F(K, ) =
ATM
+c
1
((K, )
ATM
) +c
2
((K, )
ATM
)
2
(45)
with (K, ) being one of the four deltas introduced before. The proof is a straight-
forward application of the implicit function theorem. Note that F(K
ATM
,
ATM
) = 0
is given by default. As already stated, the function F is differentiable with respect
to the strike and volatility. Deriving with respect to volatility yields
F
= c
1
+2c
2
(
ATM
)
1. (46)
From this derivation we have
F
(K
ATM
,
ATM
) = c
1
(K
ATM
,
ATM
) 1, (47)
which is different from zero by assumption of the theorem. Consequently, the im-
plicit function theorem implies the existence of a differentiable function f and an
open neighborhood U W IR
+
IR
+
with K
ATM
U,
ATM
W such that
F(K, ) = 0 = f (K) for (K, ) U W.
The rst derivative is dened on U and given by
f
K
=
F
K
F
for K U,
which can be calculated in a straightforward way. The function f (K) is denoted as
(K) in the theorem. The second derivative can be derived in a straightforward way
by remembering, that the volatility depends on the strike. This completes the proof.
.
Proof (Extreme Strike Behavior of Simplied Parabolic Interpolation). Let
x := log
_
K
f
_
be the log moneyness. The terms d
can be rewritten as
d
(x) :=
x
1
2
.
We then have:
lim
x
N(d
(x)) = 0, (48)
lim
x
N(d
(x)) = 1. (49)
The c
1
, c
2
terms are constants. Consequently, for the spot delta we derive:
lim
x
((x),
S
) =
ATM
c
1
ATM
+c
2
2
ATM
, (50)
which is a constant. Similarly,
lim
x
((x),
S
) =
ATM
+c
1
(e
r
f
ATM
) +c
2
(e
r
f
ATM
)
2
, (51)
which is again a constant. Equivalent results can be derived for the forward delta.
The next analysis discusses the premium adjusted forward delta case; the spot pre-
mium adjusted case is similar. Rewriting the premium adjusted forward delta in
terms of the log moneyness x yields
f pa
= e
x
N(d
(x)) = e
x
N
_
_
x +
1
2
_
_
= e
x
e
x
N
_
x +
1
2
_
.
Consequently, we have
lim
x
f ,pa
(x) = 0 = lim
x
f ,pa
(x).
This implies that
lim
x
(
f ,pa
(x),
S
) =
ATM
c
1
ATM
+c
2
2
ATM
= lim
x
(
f ,pa
(x),
S
). (52)
Note, that this limit differs from the spot delta case, since the terms a and
ATM
are
different. .
K K
2
S

e
r
f

n(d+)
K

e
r
f

n(d+)d
e
r
f

n(d+)
K
2

e
r
f

n(d+)d+
2
K
2
S,pa
e
r
f

N(d)
f

e
r
f

n(d)
f

e
r
f

Kn(d)d+
f

e
r
f

n(d)
f
K

e
r
f

n(d)d
f K
2
f

n(d+)
K

n(d+)d
n(d+)
K
2

n(d+)d+
2
K
2
f ,pa
N(d)
f

n(d)
f

Kn(d)d+
f

n(d)
f
K

n(d)d
f K
2
Table 10: Partial Delta Derivatives I

K
2
S
e
r
f

n(d+)
_
1d+d
_
K
e
r
f

n(d+)(dd+dd+d+)
S,pa
e
r
f

n(d)
_
d+
+1dd+
_
f
2
e
r
f

Kn(d)(d+dd+d++d)
f
2
f
n(d+)
_
1d+d
_
K
n(d+)(dd+dd+d+)
f ,pa
n(d)
_
d+
+1dd+
_
f
2
Kn(d)(d+dd+d++d)
f
2
Table 11: Partial Delta Derivatives II
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FX Volatility Smile Construction

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C Ce en nt tr re e f fo or r P Pr ra ac ct ti ic ca al l Q Qu ua an nt ti it ta at ti iv ve e F Fi in na an nc ce e

CPQF Working Paper Series

K : strike of the FX option,

) = FOR to buy per 1 FOR

) = DOM to sell per 1 FOR

) = DOM to buy per 1 FOR

) = DOM to buy per 1 DOM

50 100 150 200

Fig. 2: Strike region for given premium-adjusted delta. S

Table 10: Partial Delta Derivatives I

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